MARKET UPDATE
24th March
2020
What should investors do is on the lips of every market participant/advisor. An extremely hard question to answer with certainty but the following thoughts may help to provide some clarity on an obviously fluid and fast moving situation When will investors believe the measures taken will control the crisis on a number of fronts: medically, economically, and in a financial sense? When this occurs investors will be able to look across the valley or abyss and absorb bad news which is yet to come, whether in terms of the spread of the disease, the huge hit to economic activity, or corporate solvency pressures. THREE KEY POINTS INVESTORS ARE LOOKING FOR ARE: 1) Positive news on a vaccine or an antiviral drug under development 2) Evidence or the belief that we have reached peak intensity of new cases 3) Significant fiscal measures on a global basis
VACCINE OR ANTIVIRAL DRUG NEWS While there are a number of promising announcements, notably potential success with Remdesivir and Avigan (where Chinese researchers claim it has been effective in clinical trials) there has been nothing sufficiently compelling to persuade investors that a fast-track solution is at hand. One area which may hold nearer term promise is a passive vaccine, known as passive antibody therapy, where the blood of recovered Coronavirus cases is injected. This potentially offers limited life immunity with the dose needing to be repeated periodically.
PEAK INTENSITY OF NEW CASES Most countries are now following the Imperial College report on NPIs namely mitigation or suppression. Outside of the US most countries are going down the suppression route to various degrees. Imperial College argued this was the only viable strategy to control deaths. The aim is to get the transmission rate below one as quickly as possible through strict social distancing, home isolation, quarantining and closure of educational establishments. If pursued comprehensively the report argues there is a good prospect that critical care requirements will reduce after approximately 3 weeks, implying the peak intensity of cases will occur before that. One issue is whether the measures adopted to date are enough to ensure this. In Europe now belatedly including the UK this appears likely (although London remains a weak link). Other countries such as the US and Australia have not. With markets in a climate of intense fear it is difficult to know whether the emotional pull of alarming headlines will be more potent than the prospect that the peak intensity of new cases may only be a few weeks away. The other major concern is the US as if the States fails to push out suppression measures across the totality of its population the duration of the crisis will be pushed out in other words extended. If this occurs despite the sharp falls in markets which have occurred, there remains the potential for further downside. This appears to be the current US position although a rising death toll in the States may force Trump or individual States or cities to act. Assuming suppression measures are implemented globally even if this is after unwarranted delay in some countries, there is the likelihood that this will prove to be a very severe but temporary crisis, even if the exact timeline is not clear at this time. This is the conclusion that can be drawn from the experience in China, and other Asian economies such as Singapore, Hong Kong, South Korea and Taiwan, where to varying degrees some return to normality is occurring.
The point here is that whilst there is not a total absence of new cases, the incidence of these is relatively low and the total picture seems to be under control demonstrating an effectively implemented suppression regime works. Markets will clearly be concerned if a resurgence occurs in these areas especially if it came because the virus mutated. Whilst globally markets have not really reacted to the improvement in China, if there is evidence suppression can work in western democracies and is a repeatable formula in many countries markets will become more confident that the end of the economic damage is in sight. Thus over the next 2-3 weeks evidence may well emerge that in medical jargon the curve has flattened. The next question is what happens next. The Imperial report signals suppression needs to be kept in place for up to five months although temporary relaxations may be possible. A clear concern is voiced for the longer-term in the Ferguson report from Imperial College London which argues suppression measures can control the virus in the short-term, but if relaxed will result in a second wave. This if it occurred would leave economies in a depressed situation and markets would have another leg down, even from levels of up to 35% below peaks. This would be a global depression scenario. Markets would then call into question whether the extensive fiscal measures (to be discussed below) both in terms of both size and nature are enough and the sustainability of such measures over the longer-term. However some of the assumptions in the modelling on whether or not suppression cannot be relaxed are being questioned by other experts in this field and clearly Asia but especially China will lead the world on this. To date although it is early days the signs from China are encouraging. The impact of keeping in place travel restrictions and contact tracing were not assumptions used in the Ferguson report.
FISCAL MEASURES THE GFC was ended by Central Banks willingness to adopt very unconventional monetary policies. Today the crisis needs to be addressed with a similar degree of recognition that conventional thinking in terms of fiscal policy needs to be jettisoned. The good news is that most countries (even Germany) are now putting in place measures which are now more sensible in terms of their ability to provide economic support. The world is witnessing a wholesale and sharp collapse in economic activity requiring massive ‘whatever it takes’ fiscal measures to safeguard the solvency of businesses, individuals and the financial system as a whole.
In the US the measures announced in the package will be around $2.0 trillion or 10% of GDP and 30% of GDP if the $4.0 trillion lending power from the Fed is included. In the UK it is 15% of GDP. In Europe a region historically slow to react to crises the EU has suspended the budget deficit rule and Germany has brought in an E150bn supplementary budget in addition to other fiscal actions. Very importantly in these emergency conditions direct transfers of cash to individuals and corporates are part of the actions by governments globally. Clearly the loans available will only be taken up if corporates have confidence in the future and these direct cash transfers may ensure this happens as consumption should not immediately drop off a cliff. Are these measures enough? This is where the interconnectedness with the health measures becomes very important. If governments go hard early enough (as appears the case in Ireland) peak intensity is only likely to be weeks away, with the prospect of some gradual return to normality not long after. If this is the case the scale of fiscal measures announced should be enough to avoid economic disaster. The cash hand out should help alleviate individuals having to run down savings which would hit consumer activity in the recovery phase. If individuals can return to jobs there could be a surge of pent up demand on leisure activities in particular. Governments seem to have learnt from the GFC that significant long term rises in unemployment have long lasting consequences, not only in terms of consumption, but also government fiscal positions as those in work pay tax (PAYE and VAT to name but two). Moreover if businesses can see a clear path to daylight on the health side, then their willingness to utilise the cheap loans on offer becomes much greater.
Whilst monetary policy is not the decisive driver in current circumstances in contrast to the Financial Crisis keeping interest rates low and ensuring the liquidity of the financial system are essential. This includes the efficient functioning of corporate credit and in the US the MBS markets. The US Federal Reserve has now embarked on what is in reality unlimited QE along with substantial bond buying programs around the world and extended loan facilities. These might even at some stage include riskier credit or equities. These measures are already eye opening in terms of size. A further medical/economic point to consider is that some governments may tolerate a modest rise in the transmission rate to allow the economy to function better. Some medical experts are floating the idea of utilising limited herd immunity. This would involve identifying a pool of workers, who having tested positive but then recovered can work normally as they should not get re-infected. This would be most valuable in healthcare, but could be applied across a number of industries and allow a phased return to some form of normalisation. It requires widespread testing as many people may have the virus in such a mild form they do not realise it. There has also been speculation some stock markets might close and this has happened in the Philippines and is not without precedent in many emerging markets. If this did occur it is unlikely they would be allowed to reopen unless news was significantly better so would gap up not down on the reopening. There are also studies suggesting investor sentiment has reversed course from the bull market and that risk parity funds have extremely low equity content and CTAs are net short equities (Source the Heisenberg Report 22.03.20). Overall quant strategies are short equities and a rally could result in a rapid unwind of these negative positions so at some point there will be a very sharp rebound, even if only a bear market rally.
CONCLUSION Investors have now witnessed one of the fastest declines in stock market history admittedly on one of the biggest threats the market has faced. It is easy to be consumed and overly influence by the immediate gloom. Trying to step back from this the 3 factors consistently referred to in Market Outlook pieces will drive the long-term direction of markets. These are Fundamentals, Valuation and Sentiment. Fundamentals have clearly deteriorated and sentiment is negative. Valuation is harder to asses as historic and especially current forecast PEs are meaningless. Price to book could be a more appropriate valuation measure and even historic dividend yields will not be accurate in the light of already announced dividend cuts/suspensions. Clearly corporates have zero visibility at present. Today’s crisis is unique with governments outside of the states now deliberately steepening the recession curve in order to flatten the infection curve to save lives. We are witnessing an economic stop which brings huge risks. To avoid these governments need to step up with fiscal support of truly emergency proportions to secure the financial survival of both businesses and individuals until such time as the health crisis passes. Thankfully this is now at last happening on a global basis and is supported by the monetary policies of central banks. This combination of economic and medical policies (supression) should drive a market rally. The short-term caveat is the influence of the situation in the US on global markets as it is likely in the developed world ex the US infection rates will drop substantially over the next 2-3 weeks. Markets are heavily oversold and this is also a positive.
Markets rallied on the passing of the US stimulus package but as the US has not tightened up restrictions and case numbers continue to rise this will be hard to sustain in the short-term. The trigger for an initial meaningful rally lasting more than a few days is likely to be signs of peak intensity in the west including the US, or a belief that suppression will be introduced effectively there. At the moment estimates suggest that only around 42% of the US population live in areas where restrictions or suppression measures have been put in place. Investors will have to weigh up the possibility of lower markets before this decline in numbers is reached, versus the prospects of a sizeable rally even if it is only a bear market rally when news improves. When evidence emerges that measures to control new outbreaks globally are in place or after a further sell off there are arguments in favour of committing some cash to equities. A long-term rally (the start of a new bull market) will need evidence that suppression can be relaxed without a massive spike in the re-infection rate or a vaccine emerges that is widely available. In other words economic reality or something like it can return. Until there is certainty on this some cash should be held back as there are still significant risks for markets if the economic downturn lasts longer and turns into a global depression even if this is not the central case. Investors will also have to live with heightened volatility in both directions especially in the US where a huge volume of trading is done in a mechanistic manner. This is the big structural change in markets over the past few years which has contributed to the exceptional daily volatility seen (Last night the S&P500 was up 20% from its intra-day low) and to which investors need to take heed. STRATEGY TEAM IRC 26.03.20